Modern Money Theory (MMT) vs. Structural Keynesianism

Extreme budget hawks see very deficit as a dire existential threat. A journalist sent me some questions about MMT. My answers are below.

What are the major flaws you see within Modern Monetary Theory?

(A) I like to say that MMT is a mix of “old” and “new” ideas. The old ideas are well known among Keynesian economists and are correct, but the new ideas are either misleading or wrong.The essential old idea, which everybody knows, is government has the power to issue money. We used to talk of “printing” money. In today’s electronic world we talk about “keystroke” money created by electronic credit entries.Everyone knows that because government has the capacity to create money, it can always pay its bills and debts by printing money. But having the capacity is not the same thing as saying it should, which is the beginning of where MMT goes astray.

In economic debate and economic journalism there is a “demand for difference”. On one side you have extreme budget hawks who see every deficit as a dire existential threat. MMT is the counterpart to the hawks. And here’s the rub. MMT is needed as an antidote to austerity hawks, but neither make for good economic theory.That creates a dilemma for progressive economists. On one hand, there is need for a powerful progressive polemic to counter neoliberal austerity polemic. The basic MMT message that government has a lot more fiscal space than mainstream economists say, is correct. On the other hand, MMT’s theoretical arguments are not novel, and are sometimes incorrect.

(B) I have found it is difficult arguing with MMT economists because they tend to change their positions. But here are some objections I have made in the past. First, MMT economists used to say it is easy to have full employment without inflation. I don’t think that is true. As you edge toward full employment, inflation will increase.

Second, MMT economists tend to say the central bank should park the interest rate at zero and forget about it. I think that is crazy. It is throwing away an important economic policy tool, and it would likely promote dangerous asset price inflation and financial instability which would come back to haunt us.

Third, MMT economists say all a country needs is a floating exchange rate, and then it can use money financed budget deficits that push the economy to full employment. I think that is nonsense. Just ask an economist from Mexico or Brazil. Exchange rates matter a lot for economies, and the effects of exchange rates and exchange rate volatility ramify widely, often with very disruptive consequences. The failure of MMT to provide good guidance for countries like Mexico is important. Economics should provide theory that holds up widely. MMT does not, which is a warning sign something is wrong.The size of government deficits and how they are financed matters. Deficits involve issuing financial liabilities, and different financing policies involve issuing different mixes of liabilities. The extent and mix of liability issue can have consequences.

Fourth, MMT says government can spend its way to full employment by printing money and, when the economy hits full employment, government can just raise taxes and drain the money back out. That is a naïve view. First, the economy is made up of lots and lots of sub-economies so that some reach full employment long before others. That is why inflation starts to appear before full employment. Second, government does not just push a button so that taxes go up or spending goes down. There are vested interests working to stop their taxes being raised and stop favored spending programs being cut. MMT takes no account of these political complications, which adds a further dimension of critique.

Once MMT starts addressing these critiques, it collapses into fairly standard Keynesian economics. But MMT does not want to acknowledge that because it undercuts its policy polemic and claim to fame.

Could MMT ever provide an effective method for making policy decisions in the U.S.?

(A) MMT is best understood as political polemic, aimed at beating back the budget deficit hawks. It does not add to economic theory, so talking of policy being made according to MMT does not make sense. As a political polemic, it has done a lot of good by riposting the budget hawks and by persuading people that government has much more financial space than the hawks say. Keynesians have also said that for a long time, arguing we can use budget deficits to fight recessions, finance infrastructure, and pay for part of on-going spending.

During the last recession, we did finance the budget deficit by “printing” money, but we did it in a two-stage transaction called QE (Quantitative Easing). The government sold bonds, and the Federal Reserve then bought those bonds with “printed” money. That was standard Keynesian economics, which shows MMT adds nothing new to public finance theory.

However, owing to political and intellectual failure, budget deficits were not large enough in the early stages of the recession and recovery. And nor did we use the money in the best possible ways.

(B) The challenge is twofold. First, we need to get Keynesians who had lost heart in fiscal policy to get back on board, and we need to beat back the budget hawks who say deficits are the end of the world. Unfortunately, much of the economics profession is made up of budget hawks owing to the triumph of neoliberalism and Milton Friedman’s Chicago School of economics.

Second, we need to persuade the general public about the role of government. Persuade people we need government to stabilize the economy. Persuade them that government should provide things (like health insurance & education) because the market is riddled with market failure & provides these vital things expensively, incompletely, and at a low level of quality. And persuade them that government has a lot of space to finance the programs we want.

But from an academic standpoint, there is a danger of over-stating how easy it is to finance these things. Yes, governments are different from households. They have the ability to borrow from future generations; they can issue money; and they can create a demand for their money by imposing taxes. But that does not mean they are free from market constraints and market competition, and they also confront difficult political constraints. That limits what governments can do.

MMT tends to oversimplify and understate these restraints. That is part of its political polemic which helps sell it. That makes for good politics but not good economic theory.

3. What economic theories do you believe are better suited for informing decisions on government spending?

I have long advocated a theory which I call “structural Keynesianism”.The starting point is the Keynesian idea that a large number of problems in capitalist economies are related to aggregate demand, and especially aggregate demand shortage.

Economic policy needs to ensure that the process of demand generation is robust and sustainable so that it supports full employment. That means paying attention to income distribution because income distribution affects aggregate demand. It also means having the right institutions and regulations that help ensure a robust income distribution, help prevent monopoly, and help prevent financial instability. Government is a critical part of the structure. To set and enforce the rules of the game; to stabilize the economy in booms and busts, and to provide important things we need.

Doing that needs financing, which is why we must understand government finances. Budget hawks draw an analogy between households and government. That is an incorrect bad analogy. Governments have much more financial space than households, but that does not mean they are as financially unconstrained as MMT seems to suggest.

Lastly, the extent to which government is financially constrained depends on policy. That is why I have long advocated quantitative regulation, to strengthen monetary policy and increase government’s financial space.

Thomas Palley

Thomas Palley is Schwartz economic growth fellow at the New America Foundation; Senior Economic Policy Adviser, AFL-CIO. His most recent book “From Financial Crisis to Stagnation” has just been released in paperback by Cambridge University Press (February 2013).

Member of Insight Editorial board.